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It seems like the fundamental misconception causing all this confusion around foreign trade is the idea that if we’re not exporting more than we’re importing, we’re therefore “losing money” to foreign competitors – that if we’re paying foreigners to make all our products, we’re giving away all our national wealth (and our jobs) and thereby impoverishing ourselves. But as some of the previous quotations have already mentioned, this assumption completely misses the fact that when we buy things from overseas, we’re paying for them with American dollars, which are only redeemable in America – meaning that at some point, they’ll have to find their way back to the US, where they’ll be spent on American products, creating American jobs to meet that demand, just as they would if they’d remained within US borders all along. To say that this is a “losing” proposition for the US is to misunderstand the whole nature of the arrangement; and in fact, at some level, insisting that we must export more than we import betrays a basic confusion about the whole function of earning and spending money in the first place. Friedman and Friedman elaborate on this point, and provide some additional insight into exactly how all this works:

The supporters of tariffs treat it as self-evident that the creation of jobs is a desirable end, in and of itself, regardless of what the persons employed do. That is clearly wrong. If all we want are jobs, we can create any number—for example, have people dig holes and then fill them up again, or perform other useless tasks. Work is sometimes its own reward. Mostly, however, it is the price we pay to get the things we want. Our real objective is not just jobs but productive jobs—jobs that will mean more goods and services to consume.

Another fallacy seldom contradicted is that exports are good, imports bad. The truth is very different. We cannot eat, wear, or enjoy the goods we send abroad. We eat bananas from Central America, wear Italian shoes, drive German automobiles, and enjoy programs we see on our Japanese TV sets. Our gain from foreign trade is what we import. Exports are the price we pay to get imports. As Adam Smith saw so clearly, the citizens of a nation benefit from getting as large a volume of imports as possible in return for its exports, or equivalently, from exporting as little as possible to pay for its imports.

The misleading terminology we use reflects these erroneous ideas. “Protection” really means exploiting the consumer. A “favorable balance of trade” really means exporting more than we import, sending abroad goods of greater total value than the goods we get from abroad. In your private household, you would surely prefer to pay less for more rather than the other way around, yet that would be termed an “unfavorable balance of payments” in foreign trade.

The argument in favor of tariffs that has the greatest emotional appeal to the public at large is the alleged need to protect the high standard of living of American workers from the “unfair” competition of workers in Japan or Korea or Hong Kong who are willing to work for a much lower wage. What is wrong with this argument? Don’t we want to protect the high standard of living of our people?

The fallacy in this argument is the loose use of the terms “high” wage and “low” wage. What do high and low wages mean? American workers are paid in dollars; Japanese workers are paid in yen. How do we compare wages in dollars with wages in yen? How many yen equal a dollar? What determines that exchange rate?

Consider an extreme case. Suppose that, to begin with, 360 yen equal a dollar. At this exchange rate, the actual rate of exchange for many years, suppose that the Japanese can produce and sell everything for fewer dollars than we can in the United States—TV sets, automobiles, steel, and even soybeans, wheat, milk, and ice cream. If we had free international trade, we would try to buy all our goods from Japan. This would seem to be the extreme horror story of the kind depicted by defenders of tariffs—we would be flooded with Japanese goods and could sell them nothing.

Before throwing up your hands in horror, carry the analysis one step further. How would we pay the Japanese? We would offer them dollar bills. What would they do with the dollar bills? We have assumed that at 360 yen to the dollar everything is cheaper in Japan, so there is nothing in the U.S. market that they would want to buy. If the Japanese exporters were willing to burn or bury the dollar bills, that would be wonderful for us. We would get all kinds of goods for green pieces of paper that we can produce in great abundance and very cheaply. We would have the most marvelous export industry conceivable.

Of course, the Japanese would not in fact sell us useful goods in order to get useless pieces of paper to bury or burn. Like us, they want to get something real in return for their work. If all goods were cheaper in Japan than in the United States at 360 yen to the dollar, the exporters would try to get rid of their dollars, would try to sell them for 360 yen to the dollar in order to buy the cheaper Japanese goods. But who would be willing to buy the dollars? What is true for the Japanese exporter is true for everyone in Japan. No one will be willing to give 360 yen in exchange for one dollar if 360 yen will buy more of everything in Japan than one dollar will buy in the United States. The exporters, on discovering that no one will buy their dollars at 360 yen, will offer to take fewer yen for a dollar. The price of the dollar in terms of yen will go down—to 300 yen for a dollar, or 250 yen, or 200 yen. Put the other way around, it will take more and more dollars to buy a given number of Japanese yen. Japanese goods are priced in yen, so their price in dollars will go up. Conversely, U.S. goods are priced in dollars, so the more dollars the Japanese get for a given number of yen. the cheaper U.S. goods become to the Japanese in terms of yen.

The price of the dollar in terms of yen would fall until, on the average, the dollar value of goods that the Japanese buy from the United States roughly equaled the dollar value of goods that the United States buys from Japan. At that price everybody who wanted to buy yen for dollars would find someone who was willing to sell him yen for dollars.

The actual situation is, of course, more complicated than this hypothetical example. Many nations, and not merely the United States and Japan, are engaged in trade, and the trade often takes roundabout directions. The Japanese may spend some of the dollars they earn in Brazil, the Brazilians in turn may spend those dollars in Germany, and the Germans in the United States, and so on in endless complexity. However, the principle is the same. People, in whatever country, want dollars primarily to buy useful items, not to hoard.

Another complication is that dollars and yen are used not only to buy goods and services from other countries but also to invest and make gifts. Throughout the nineteenth century the United States had a balance of payments deficit almost every year—an “unfavorable” balance of trade that was good for everyone. Foreigners wanted to invest capital in the United States. The British, for example, were producing goods and sending them to us in return for pieces of paper—not dollar bills, but bonds promising to pay back a sum of money at a later time plus interest. The British were willing to send us their goods because they regarded those bonds as a good investment. On the average, they were right. They received a higher return on their savings than was available in any other way. We, in turn, benefited by foreign investment that enabled us to develop more rapidly than we could have developed if we had been forced to rely solely on our own savings.

In the twentieth century the situation was reversed. U.S. citizens found that they could get a higher return on their capital by investing abroad than they could at home. As a result the United States sent goods abroad in return for evidence of debt—bonds and the like. After World War II, the U.S. government made gifts abroad in the form of the Marshall Plan and other foreign aid programs. We sent goods and services abroad as an expression of our belief that we were thereby contributing to a more peaceful world. These government gifts supplemented private gifts—from charitable groups, churches supporting missionaries, individuals contributing to the support of relatives abroad, and so on.

None of these complications alters the conclusion suggested by the hypothetical extreme case. In the real world, as well as in that hypothetical world, there can be no balance of payments problem so long as the price of the dollar in terms of the yen or the mark or the franc is determined in a free market by voluntary transactions. It is simply not true that high-wage American workers are, as a group, threatened by “unfair” competition from low-wage foreign workers. Of course, particular workers may be harmed if a new or improved product is developed abroad, or if foreign producers become able to produce such products more cheaply. But that is no different from the effect on a particular group of workers of other American firms’ developing new or improved products or discovering how to produce at lower costs. That is simply market competition in practice, the major source of the high standard of life of the American worker. If we want to benefit from a vital, dynamic, innovative economic system, we must accept the need for mobility and adjustment. It may be desirable to ease these adjustments, and we have adopted many arrangements, such as unemployment insurance, to do so, but we should try to achieve that objective without destroying the flexibility of the system—that would be to kill the goose that has been laying the golden eggs. In any event, whatever we do should be evenhanded with respect to foreign and domestic trade.

[…]

Another source of “unfair competition” is said to be subsidies by foreign governments to their producers that enable them to sell in the United States below cost. Suppose a foreign government gives such subsidies, as no doubt some do. Who is hurt and who benefits? To pay for the subsidies the foreign government must tax its citizens. They are the ones who pay for the subsidies. U.S. consumers benefit. They get cheap TV sets or automobiles or whatever it is that is subsidized. Should we complain about such a program of reverse foreign aid? Was it noble of the United States to send goods and services as gifts to other countries in the form of Marshall Plan aid or, later, foreign aid, but ignoble for foreign countries to send us gifts in the indirect form of goods and services sold to us below cost? The citizens of the foreign government might well complain. They must suffer a lower standard of living for the benefit of American consumers and of some of their fellow citizens who own or work in the industries that are subsidized. No doubt, if such subsidies are introduced suddenly or erratically, that will adversely affect owners and workers in U.S. industries producing the same products. However, that is one of the ordinary risks of doing business. Enterprises never complain about unusual or accidental events that confer windfall gains. The free enterprise system is a profit and loss system. As already noted, any measures to ease the adjustment to sudden changes should be applied evenhandedly to domestic and foreign trade.

In any event, disturbances are likely to be temporary. Suppose that, for whatever reason, Japan decided to subsidize steel very heavily. If no additional tariffs or quotas were imposed, imports of steel into the United States would go up sharply. That would drive down the price of steel in the United States and force steel producers to cut their output, causing unemployment in the steel industry. On the other hand, products made of steel could be purchased more cheaply. Buyers of such products would have extra money to spend on other things. The demand for other items would go up, as would employment in enterprises producing those items. Of course, it would take time to absorb the now unemployed steelworkers. However, to balance that effect, workers in other industries who had been unemployed would find jobs available. There need be no net loss of employment, and there would be a gain in output because workers no longer needed to produce steel would be available to produce something else.

The same fallacy of looking at only one side of the issue is present when tariffs are urged in order to add to employment. If tariffs are imposed on, say, textiles, that will add to output and employment in the domestic textile industry. However, foreign producers who no longer can sell their textiles in the United States earn fewer dollars. They will have less to spend in the United States. Exports will go down to balance decreased imports. Employment will go up in the textile industry, down in the export industries. And the shift of employment to less productive uses will reduce total output.

The national security argument that a thriving domestic steel industry, for example, is needed for defense has no better basis. National defense needs take only a small fraction of total steel used in the United States. And it is inconceivable that complete free trade in steel would destroy the U.S. steel industry. The advantages of being close to sources of supply and fuel and to the market would guarantee a relatively large domestic steel industry. Indeed, the need to meet foreign competition, rather than being sheltered behind governmental barriers, might very well produce a stronger and more efficient steel industry than we have today.

Suppose the improbable did happen. Suppose it did prove cheaper to buy all our steel abroad. There are alternative ways to provide for national security. We could stockpile steel. That is easy, since steel takes relatively little space and is not perishable. We could maintain some steel plants in mothballs, the way we maintain ships, to go into production in case of need. No doubt there are still other alternatives. Before a steel company decides to build a new plant, it investigates alternative ways of doing so, alternative locations, in order to choose the most efficient and economical. Yet in all its pleas for subsidies on national security grounds, the steel industry has never presented cost estimates for alternative ways of providing national security. Until they do, we can be sure the national security argument is a rationalization of industry self-interest, not a valid reason for the subsidies.

No doubt the executives of the steel industry and of the steel labor unions are sincere when they adduce national security arguments. Sincerity is a much overrated virtue. We are all capable of persuading ourselves that what is good for us is good for the country. We should not complain about steel producers making such arguments, but about letting ourselves be taken in by them.

What about the argument that we must defend the dollar, that we must keep it from falling in value in terms of other currencies—the Japanese yen, the German mark, or the Swiss franc? That is a wholly artificial problem. If foreign exchange rates are determined in a free market, they will settle at whatever level will clear the market. The resulting price of the dollar in terms of the yen, say, may temporarily fall below the level justified by the cost in dollars and yen respectively of American and Japanese goods. If so, it will give persons who recognize that situation an incentive to buy dollars and hold them for a while in order to make a profit when the price goes up. By lowering the price in yen of American exports to Japanese, it will stimulate American exports; by raising the price in dollars of Japanese goods, it will discourage imports from Japan. These developments will increase the demand for dollars and so correct the initially low price. The price of the dollar, if determined freely, serves the same function as all other prices. It transmits information and provides an incentive to act on that information because it affects the incomes that participants in the market receive.

Why then all the furor about the “weakness” of the dollar? Why the repeated foreign exchange crises? The proximate reason is because foreign exchange rates have not been determined in a free market. Government central banks have intervened on a grand scale in order to influence the price of their currencies. In the process they have lost vast sums of their citizens’ money (for the United States close to $2 billion from 1973 to early 1979). Even more important, they have prevented this important set of prices from performing its proper function. They have not been able to prevent the basic underlying economic forces from ultimately having their effect on exchange rates, but have been able to maintain artificial exchange rates for substantial intervals. The effect has been to prevent gradual adjustment to the underlying forces. Small disturbances have accumulated into large ones, and ultimately there has been a major foreign exchange “crisis.”

Why have governments intervened in foreign exchange markets? Because foreign exchange rates reflect internal policies. The U.S. dollar has been weak compared to the Japanese yen, the German mark, and the Swiss franc primarily because inflation has been much higher in the United States than in the other countries. Inflation meant that the dollar was able to buy less and less at home. Should we be surprised that it has also been able to buy less abroad? Or that Japanese or Germans or Swiss should not be willing to exchange as many of their own currency units for a dollar? But governments, like the rest of us, go to great lengths to try to conceal or offset the undesirable consequences of their own policies. A government that inflates is therefore led to try to manipulate the foreign exchange rate. When it fails, it blames internal inflation on the decline in the exchange rate, instead of acknowledging that cause and effect run the other way.

When we talk about trade, it’s worth bearing in mind that these transactions between different countries, at the end of the day, really are trades in the literal sense of the word – which is to say, they’re always two-way exchanges. Granted, the two sides of the trade do usually occur at different times; most transactions don’t take the form of direct one-for-one barter, with (say) Americans trading bushels of wheat directly to Chinese manufacturers in exchange for new appliances. More often, one party will instead buy a product from the other – in this case, let’s say the Americans buy some appliances from the Chinese first – and then they give them some IOUs (i.e. American dollars) which can later be redeemed for bushels of wheat or whatever else the Chinese feel like buying from the Americans. It’s still a two-way trade; it’s just that it includes the use of dollars as an intermediate step to make things more convenient for everyone.

Of course, as Friedman and Friedman rightly point out (echoing Heath’s comments from earlier), the foreigners who receive our dollars don’t always decide to redeem them for consumption goods and services straight away; sometimes they put them into investment vehicles instead (i.e. stocks, bonds, bank accounts, etc.), just as regular Americans sometimes do by saving up their earnings instead of spending them all at once. But this is just another way of extending the time delay between the two sides of the trade; eventually, all the dollars that have been saved up will have to be exchanged for goods and services, or else there would be no point in accumulating them in the first place. (And if they aren’t ever spent, well, that’s even better for us, because it would mean we were able to receive a bunch of goods and services without ever having to provide anything in return other than a bunch of IOUs that would never be redeemed.) In the meantime, this outstanding “trades that have only been halfway completed” balance is essentially what a trade deficit is. That is to say, the term “trade deficit” isn’t referring to how much foreign exporters are “beating” American exporters, because such an idea doesn’t even make sense – the amount that they export to each other must always balance out in the end – rather, it’s just another term for “money currently invested in American assets.” As Taylor explains:

One important twist to remember is that, while the United States pays for its imports in U.S. dollars, the producer in, say, Japan doesn’t want U.S. dollars; it wants Japanese yen. After all, the Japanese supplier needs yen, not dollars, to pay for wages and supplies related to production in Japan. Thus, a Japanese firm that exports to the United States and receives U.S. dollars wants to trade the U.S. dollars for yen with someone in the foreign exchange market. Once the Japanese exporting firm trades its dollars for yen, where do the dollars go? One way or another, the dollars end up invested in U.S. assets. Maybe they go to someone who buys stocks, bonds, or property, or maybe that someone puts the money in a bank account; then the firm that issued the stock or bond expands its operations in the United States, or the bank lends out the money to someone who wishes to buy or build or invest in the United States, and so on. The dollars that flow overseas and don’t come back as goods or services represent a flow of financial investment back into the U.S. economy.

To economists, a trade deficit literally means that a nation, on net, is borrowing from abroad and receiving an inflow of investment from abroad. For exactly the same reasons, a trade surplus literally means that a nation, on balance, is lending money abroad and having an outflow of foreign investment. A trade surplus and a trade deficit aren’t just about the flow of goods. In fact, to most economists, trade imbalances aren’t even primarily about the flow of goods. They’re about this flow of money, and whether the flow is bigger in one direction or another.

And one of the more ironic things about this, despite all the popular fear about trade destroying American jobs, is that when foreign holders of dollars are deciding what to invest in, it’ll often turn out that their best option is to turn around and put that money back into opening new facilities on American soil, thereby directly creating more American jobs themselves. As Sowell writes:

In some years, the best-selling car in America has been a Honda or a Toyota, but no automobile made in Detroit has been the best-selling car in Japan. The net result is that Japanese automakers receive billions of dollars in American money and Japan usually has a net surplus in its trade with the United States. But what do the makers of Hondas and Toyotas do with all that American money? One of the things they do is build factories in the United States, employing thousands of American workers to manufacture their cars closer to their customers, so that Honda and Toyota do not have to pay the cost of shipping cars across the Pacific Ocean.

Their American employees have been paid sufficiently high wages that they have repeatedly voted against joining labor unions in secret ballot elections. On July 29, 2002, the ten millionth Toyota was built in the United States. Looking at things, rather than words, there is little here to be alarmed about. What alarms people are the words and the accounting rules which produce numbers to fit those words.

It’s true, words like “deficit” and “unfavorable balance of trade” can sound scary, because they’re loaded with so many negative connotations that we associate with things like onerous personal debts. But once we understand what trade deficits actually are and how they work, they turn out not to be so scary after all. As Caplan puts it:

Trade deficits, contrary to popular opinion, are not a bad thing. Whenever the trade deficit goes up, people always want to ‘do something’ about it, but they’re wrong—like all trade, international trade is mutually beneficial, whether or not there is a trade deficit. […] I run a huge trade deficit with Wegmans Supermarket—I buy thousands of dollars of its groceries, but Wegmans buys nothing from me—and it is nothing to worry about.

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